Warren Buffett is one of the most successful investors of all time. His knack for investing in undervalued businesses and watching them grow has landed him on the list of the wealthiest people in the world (fun fact: Warren Buffett’s net worth rose a staggering $37 Million per day in 2013). While becoming one of the wealthiest people in the world himself, he has also helped a number of other wealthy people by allowing them to purchase shares in his holding company, Berkshire Hathaway. The company has averaged an annual growth rate of roughly 20% over the last 49 years while the S&P 500 has averaged 9.8%.
Perhaps what I love most about Warren (yes, we’re on a first-name basis) is what he does for the average investor. Rather than getting a big-head and telling everyone how easy it is to follow in his footsteps and “beat the market,” Warren recognizes the limitations of the average investor. To reiterate Warren’s simple advice from this recent article:
The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 Index Fund will achieve this goal.
Warren put his money where his mouth is by:
1. Ordering the trustee of his will to invest 90% of his fortune in a low-cost index fund from Vanguard.
2. Betting $1 Million that the S&P 500 will outperform hedge funds over a 10 year period.
The Results of the Million Dollar Bet are Good News for You and Charity
According to the website A Long Bet, Warren specifically challenged that:
Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.
Protege Partners, a money manager, accepted the challenge and agreed that the stakes of $1 Million be awarded to the charity of the winners choice.
Warren’s argument:
A lot of very smart people set out to do better than average in securities markets. Call them active investors.
Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.
A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.
Protege’s argument:
Mr. Buffett is correct in his assertion that, on average, active management in a narrowly defined universe like the S&P 500 is destined to underperform market indexes. That is a well-established fact in the context of traditional long-only investment management. But applying the same argument to hedge funds is a bit of an apples-to-oranges comparison.
Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.
There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages. Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.
The Results (after 7 years)
Through the first seven years, Vanguard’s index fund (tracking the S&P 500) is up 63.5%. Protege’s five hedge funds of funds are up an estimated 19.6% on average. Source
The official scoreboard looks something like this:
Passive Investing: 6
Passive investors will purchase investments with the intention of long-term appreciation and limited maintenance. (Definition from Investopedia)
Active Investing: 1
Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions. (Definition from Investopedia)
Something to Consider
Unfortunately, the five hedge funds selected for this contest are not disclosed to the public. This greatly limits the usefulness of further analysis since we don’t know how much risk is being taken to achieve such returns. Index funds, while a great investment option during bull markets, provide no protection when times turn sour. On the other hand, hedge funds, in historical terms, are meant to maximize returns while also “hedging” against downside risk. In recent practice, however, hedge funds can carry more risk than the overall market.
Having said that, it’s still good news that you (the average investor) can potentially find the same (if not better) returns than the uber-wealthy by paying less attention to your investments.
photo credit: DonkeyHotey
